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When raising capital, many early-stage or credit-starved firms turn to convertible bonds or similar instruments to entice investors while limiting the near-term cash flow burden of interest payments. Bonds and preferred stock with conversion features or attached warrants (referred to as “Convertibles”) often have two key features that deviate from plain-vanilla financing: (1) the stated interest rate on the Convertible is likely below market rates for non-convertible financing and (2) the Convertible investor gains equity exposure via the conversion feature or warrant.

While Convertibles can provide the issuer operational flexibility by limiting interest or dividend payments, Convertibles can also create accounting and valuation challenges for the reporting entity at issuance of the instrument, as well as in subsequent reporting periods.

Overview of Convertibles

Convertibles are hybrid securities that exhibit characteristics of both debt and equity. Convertibles are debt-like in that investors earn periodic coupon or dividend payments, maintain liquidation preference over common stock, and may have a definitive maturity date (if the security is not converted) at which time the investor receives the full principal amount plus accrued but unpaid interest. Convertibles are equity-like in that the investor has the right to convert the security into a predetermined number of common shares at any time prior to maturity (to the extent it is economically advantageous) and typically have voting rights on an “as-if” converted basis throughout the life of the Convertible.

Plain-vanilla Convertibles are essentially equity call options attached to a straight bond.

Given their hybrid nature, Convertibles are often viewed as a straight bond plus an equity call option. A company issuing Convertibles is effectively exchanging call options on its equity in favor of a lower cost of debt financing.

In addition to the above characteristics, Convertibles often have additional call and put provisions. The call allows the issuer to buy back the security at a predetermined price, and consequently limit the investor’s returns if interest rates fall or stock prices rise. The put allows the investor to return the Convertible to the issuer for cash, thus providing additional downside protection.

Issuers have several reasons to use Convertible financing, including:

The company can lower the cash flow burden of its debt financing compared to straight debt (or preferred stock) alone. In periods of rising stock prices or high volatility, the reduction in coupon or dividend payments can be substantial.

Lower-credit companies that may not be able to access the traditional debt or preferred stock markets can more readily find financing via Convertibles.

Companies that anticipate equity appreciation can use Convertibles to defer equity financing to a time when growth has been achieved, thus lowering interim dilution.

Convertibles allow issuers to pay lower interest rates in exchange for a share of the upside in its equity, and generally increase flexibility for the issuer.

Applicable Accounting Guidance

The accounting literature pertaining to Convertibles is complex—which is to be expected given that Convertibles often have highly unique attributes that are specific to each security. In general, Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 815, Derivatives and Hedging (“FASB ASC 815,” formerly known as SFAS 133) governs derivatives embedded in Convertibles. Further, any aspect of the Convertible that is measured at fair value must adhere to FASB ASC Topic 820, Fair Value Measurements and Disclosures (“FASB ASC 820”).

The FASB views Convertibles as “hybrid instruments,” which are defined as contracts that embody both (a) a host contract and (b) an embedded derivative. The straight bond component of a Convertible is viewed as the host contract and the equity call option component is viewed as the embedded derivative.

Separately identified embedded derivatives must be measured at fair value on each balance sheet date, with changes in fair value flowing through earnings.

When evaluating the appropriate accounting treatment for Convertibles, the principal issue addressed in this article pertains to whether the embedded derivative requires separate recognition from the host contract. Separately identified derivatives must be measured at fair value on each balance sheet date, with changes in fair value flowing through earnings. However, the host contract (i.e. the straight debt component) may not require fair value measurement in subsequent reporting periods. Accordingly, the accounting treatment can be particularly critical for reporting entities that issue Convertibles due to the potential impact on earnings volatility.

FASB ASC 815-15-25 outlines three primary criteria that must be met in order for derivatives embedded in a Convertible to be accounted for as a separate liability:

The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract. That is, if the economic characteristics and risks of the two components of a Convertible are closely related, the embedded derivative does not require separate recognition.

The hybrid instrument is not re-measured at fair value under otherwise applicable generally accepted accounting principles (“GAAP”), with changes in fair value reported in earnings as they occur. If the hybrid instrument is already reported at fair value under other applicable GAAP, there is no need to separately recognize the embedded derivative since changes in the derivative’s fair value would already be incorporated in the fair value measurement of the security as a whole.

A separate instrument with the same terms as the embedded derivative would be considered a derivative subject to the requirements of this FASB ASC 815. If the embedded derivative would not necessitate fair value measurement on a standalone basis, there is no need to separate the derivative from the host contract.

In addition to the factors outlined above, the appropriate accounting treatment for the Convertible may differ based on the settlement alternatives for the instrument, particularly in the case of convertible preferred stock. Convertible preferred stock may be classified as equity or as a liability on the balance sheet, depending on whether the security may ultimately be settled in cash or in shares of common stock. While all Convertibles must initially be measured at fair value, Convertibles that are classified as equity may not require subsequent measurement at fair value, whereas Convertibles that are classified as liabilities must be re-measured at fair value, with changes in fair value being reported in earnings.

In general, unless the economic substance of the instrument indicates otherwise, Convertibles are initially classified as liabilities in both of the following situations:

The balance sheet classification for Convertibles generally depends on whether the instrument is assumed to be settled in cash (liability) or shares (equity).

Conversely, Convertibles are initially classified as equity in both of the following situations:

If the Convertible requires physical settlement or net share settlement upon conversion or maturity.

If the Convertible gives the reporting entity (i.e. the issuer of the Convertible) the choice of a net cash settlement or settlement in shares.

Valuation Methodology

In the event that a reporting entity determines that an embedded derivative requires separate recognition, it is necessary to determine its fair value as of each reporting period. Given the unique characteristics of Convertibles, and in the absence of reliable quoted market prices for comparable instruments, a lattice or binomial option pricing model is typically the most appropriate valuation approach. A lattice or binomial approach is a preferred valuation methodology relative to a closed-form option pricing model (e.g. the Black-Scholes option pricing model) since it allows increased flexibility that is critical when valuing complex derivative instruments.

The lattice or binomial option pricing model is a preferred approach when valuing Convertibles.

The binomial model utilizes a “decision tree” whereby future movement in the subject company’s common stock is estimated based on a volatility factor. Once the binomial lattice has been developed for the common stock, the next step is to build a corresponding tree of future Convertible values based on the greater of (a) the principal amount of the Convertible, (b) the conversion value of the Convertible, or (c) the potential future value of the Convertible if conversion is deferred (based on projected future prices for the common stock). These future values are then discounted to the valuation date based on a risk-neutral framework using a credit-adjusted discount rate.

The credit-adjusted discount rate, calculated at each node (or time period) in the binomial tree, is simply a probability-weighted rate of return derived by the sum of (a) the product of (i) the probability of converting into common stock and (ii) the risk-free rate (since hedging the option with common stock results in a riskless investment over a short time period) and (b) the product of (i) one minus the probability of converting into common stock and (ii) a “risky” market yield on debt for the issuer (since the debt component remains subject to default and other debt-related risks). In general, the “risky” market yield on debt will always be greater than the stated interest rate on the Convertible since the instrument should theoretically have preferable terms from an interest perspective. This is because the issuer effectively traded equity call options in exchange for a lower interest rate.

Finally, in order to separate the bond component from the embedded derivative contained in a Convertible, it is possible to recalculate the binomial model such that conversion does not occur in any node. By setting the common stock value as of the valuation date to $0, the company’s common stock in the binomial tree will never appreciate to a level sufficient to make it economically advantageous to exercise the conversion feature. The resulting value represents the Convertible’s value as if there were no conversion feature (i.e. the bond component). Finally, subtracting the bond component from the total fair value of the Convertible results in the value of the embedded derivative.

In order to illustrate the potential impact that embedded derivatives can have on a reporting entity’s financial statements, let’s assume that ABC Company, Inc. (“ABC”) issued a $50.0 million convertible note on December 31, 2007, due December 31, 2012, with a stated interest rate of 7.5% per annum (the “Note”). The Note is convertible into 5.0 million shares of ABC’s common stock, for an effective conversion threshold of $10.00 per share. That is, it is economically advantageous to convert the Note to common stock if ABC’s common stock exceeds $10.00 per share. Finally, we assume that ABC’s common stock is trading at $7.50 per share on December 31, 2007.

ABC management and its auditors have determined that the conversion feature embedded in the Note is required to be accounted for separately as a derivative liability. Separation of the conversion feature as a derivative liability is required because a redemption feature in the Note allows the holders a mechanism to “net settle” the conversion feature into cash at the investor’s election. Further, the embedded conversion feature’s economic characteristics are considered more akin to an equity instrument and are therefore not considered to be clearly and closely related to the economic characteristics of the Note, which is considered more akin to a debt instrument than equity, due to the scheduled maturity date. Accordingly, ABC must record an embedded derivative liability representing the fair value of the conversion option, and the liability must be measured to fair value at each subsequent reporting date with changes in fair value being recorded on the income statement.

Table 2 outlines the inputs and outputs of a binomial model analysis for the Note as of the issuance date, as well as the subsequent two fiscal year ends. Based on the inputs summarized on lines 4 through 10, the fair value of the embedded derivative is

$11.9 million on December 31, 2007, and the fair value of the Note’s bond component is $38.1 million, for a total fair value of $50.0 million (which equates to the Note’s issue price). As a result, the bond component of the Note is determined to have an effective market rate of interest (the “risky” market yield) of 14.5%, relative to the stated interest rate of 7.5%. To corroborate the results of this analysis, an analysis of market yields for non-convertible bonds issued by companies with similar credit quality to ABC indicates that the 14.5% market yield is reasonable.

Moving forward one year, we assume that ABC’s common stock price decreases by 20% to $6.00 per share and the market yield for non-convertible bonds with similar credit quality increases to 17.5%. Recalculating the fair values results in a $5.9 million decrease in the value of the embedded derivative and a $1.7 million decrease in the value of the Note’s bond component. One year later, we assume that ABC’s common stock price increases by 33% to $8.00 per share and the market yield for non-convertible bonds with similar credit quality decreases to 12.5%. Recalculating the fair values results in a $3.4 million increase in the value of the embedded derivative and a $7.6 million increase in the value of the Note’s bond component.

Table 3 outlines the impact of this valuation analysis from a financial statement perspective. The embedded derivative is stated at fair value on each balance sheet date (line 2) with changes in the fair value flowing through earnings as a gain or loss (line 4). While the bond component of the Note is initially measured at fair value, it is not re-measured at fair value on subsequent balance sheets. Rather, the bond component accretes up to face value (i.e. $50.0 million) as the Note’s maturity date draws near. As a result, the income statement is not affected by changes in fair value, but rather (a) cash payments of interest (line 5, calculated based on the stated interest rate of 7.5% on a face value of $50.0 million) and (b) the implied interest expense associated with accretion (line 6). Moreover, the effective interest rate on the Note’s bond component is 14.5%, which equates to the non-convertible market yield as of the issuance date (see Table 2).

As a contrast to the above example, Table 4 outlines an alternative scenario in which ABC issues a note without a conversion feature, opting instead to issue a $50.0 million note with a stated interest rate of 14.5% (the non-convertible market yield on the issuance date). As shown, the interest-bearing debt account on the balance sheet remains at $50.0 million with no fair value adjustments between reporting periods. Moreover, the income statement impact is far less volatile, as only cash interest payments affect earnings. Of course, the downside to this scenario is that ABC would have higher cash outflows for interest expense relative to issuing convertible debt.

Convertible securities are complex financial instruments with equally complex accounting and valuation challenges, particularly given that changes in value may have a significant impact on earnings per share and other financial metrics deemed important by investors. Each instrument is unique, requiring a sound understanding of the accounting regulations as well as the assumptions employed in valuing these securities. These challenges underscore the importance of clear communication, cooperation, and thoughtful contemplation between financial statement preparers, auditors, and valuation experts.